The importance of fixed export costs

Posted
by on 16 September 2010

In a recent Vox column, Lucian Cernat – Chief Trade Economist of the European Commission – called on his colleagues to contribute to a public debate on the direction of the EU’s future trade policy (Cernat, 2010). One of the questions he addresses concerns policy’s ability to address “beyond-tariff” trade barriers. Because traditional trade policies have already achieved major progress in the past decades, the relative importance of these non-tariff barriers has increased substantially. As these barriers are intimately related to a country’s institutions, not only does lowering them require a long-term perspective, they might also pose limits to what trade policies can ultimately achieve.

Fixed export costs

The heterogeneous firms literature in international trade research has made clear that non-tariff or institutional barriers are a crucial impediment for firms to export their goods abroad. In particular, they may function as a fixed export costs that firms have to overcome before they are able to serve foreign markets (Melitz, 2003; Chaney, 2008). As a result, only the world’s best, biggest and brightest firms are capable of doing so (Bernard et al., 2007). For example, in a recent study of 15,000 firms in 7 European countries, Barba Navaretti et al. (2010) estimate that big firms (>249 employees) are between 20-40 %-points more likely to engage in exports than small firms (10-19 employees). Furthermore, their subsequent export shares are also substantially higher.

By implication, many countries still face a lot of unexploited trade potential in the form of firms that are willing yet unable to venture abroad. Reducing these fixed export costs provides rich but complex opportunities for policy to facilitate firms in establishing new export relationships. These go beyond traditional trade policies like reducing tariffs and quotas, which are more suitable to deepen already existing trade relationships.

Researchers have tried to verify the existence and quantify the magnitude of fixed export costs (e.g. Das et al., 2007). Although insightful from an academic perspective, these results are of little use to policy makers because it is unclear what they actually entail. In a recent study, we have made a first attempt to open the black box and explicitly capture some aspects of fixed export costs (Smeets et al., 2010).

Institutions matter

There is a consensus that poor institutional quality and national cultural differences form important impediments to economic exchange in general (e.g. Guiso et al., 2009) and international trade in particular (e.g. De Groot et al., 2004). The reason is that poor institutional quality increases uncertainty about the circumstances in which potential exporters will have to operate, e.g. due to the risk of expropriation of (intellectual) property. That is, poor institutional quality tends to increase transaction costs. More specifically, in light of the new firm-level trade literature, we might expect it to increase fixed export costs as well.

To explore this possibility, we estimate a standard gravity model to explain both country-specific export decisions and (subsequent) export volume decisions, for a sample of 1,200 large firms in the Netherlands during the years 2006-2007. In order to capture (pieces of) fixed export costs, we employ measures on inter alia the quality of governance and regulation (Kaufmann et al., 2009), the extent of national corruption (Heritage, 2010), and cultural distance (KOF, 2009).

Our findings confirm that the “usual suspects” in the gravity literature – market size, geographic distance, and tariffs – all affect exports in the expected way, but that their effect is much more pronounced in explaining export volume decisions rather than the export decisions themselves.

What about fixed export costs? The defining characteristic of a fixed export cost is that it affects a firm’s initial decision to export to a particular market, but not the subsequent export volume decision. Our results indicate that the four proxies mentioned above indeed qualify as important and robust aspects of fixed export costs. In order to quantify these effects, we engage in a simple thought experiment. We ask ourselves by how much the export probability of the average firm would increase, were the country that has the lowest score on each of these measures to leap forward to the level of the best performing country.

Our results indicate the following: first, if Syria (minimum) were to increase its governance quality to the level of Norway (maximum), Dutch exporters would be 4.6 %-points more likely to export to Syria. Second, if Iran were to increase the quality of its regulations to the level of Denmark, the export probability would increase by 9.7 %-points. Third, the likelihood of Dutch firms exporting to Bangladesh would increase by 8 %-points if this country could lower its level of corruption to that in Finland. Finally, if Bangladesh could close the cultural gap with respect to the Netherlands completely, this would raise the export probability by 10 %-points.

When assessing the importance of these effects, it should be noted that the average export probability in our sample of firms is +/- 21 %-points. Hence, the estimated impacts are substantial, as they imply that firms in the Netherlands could increase their average export probability by 25% to 50% following these institutional changes.[1]

Policy implications

A number of policy lessons can be drawn. First, “promoting exports” by itself is an ambivalent policy goal. In order to determine what type of trade policy is most appropriate, it should be made more explicit. Is the goal to turn non-exporters into exporters, or to increase the export volumes of existing exporters? And in the latter case, should this be achieved by establishing new export relationships, or by deepening existing ones? Traditional trade policies are more effective to deepen existing relationships, yet less suitable to establish new ones. In order to achieve this, creating a (more) level playing field by reducing fixed export costs is more appropriate.

What can policy do to this effect? Our results suggest that it is important to realize that setting up new export relationships is not just a matter of establishing business networks, erecting the necessary infrastructures for doing business internationally, and providing firms with information about export destinations. A second lesson is that pressing for institutional and regulatory reforms abroad are just as or perhaps even more important, possibly through bilateral or multilateral negotiations. In general, policy should aim to reduce the risk of doing business in countries that now provide opportunities that are simply too uncertain for potential exporters.

A third, and perhaps somewhat less optimistic, implication of our study might be to also point out the limits of what (trade) policy can achieve. For example, even though cultural differences might be an important impediment to the formation of trade relationships, they are not likely to completely disappear. And, quite likely, nor should we want them to. In this light, it remains important to stress that (trade) policy should try to correct the market only where it fails. To the extent that fixed export costs benefit domestic firms at the expense of foreign exporters, they seem an important subject for the EU’s future trade policy.

[1]Of course, these results should be interpreted with due caution. For example, the estimated effects are extreme, in that they require full-fledged institutional reform to rain down as “manna from heaven”. Cost considerations of such reform are left out of the picture. Moreover, these effects are not likely to be partial. That is, a decrease in corruption is likely to be accompanied both by increased quality of governance as well as regulation. Indeed, the correlations between these measures are high. Hence, the estimated impacts cannot simply be added up to arrive at a total effect of full institutional reform.